The ultimate key
to success in all trading, both long-term investment and short-term
speculation, is simple. Buy low, sell high. Excel in this,
and trading the financial markets will eventually make you wealthy.
But implementing this well-known proverb into your own trading
certainly isn’t easy. As always, the devil is in the details.

To paraphrase
Pontius Pilate’s famous rhetorical question to Jesus, what is low?
What is high? In order to buy low and sell high, traders must gain
insights into how to define these conditions in real-time. Without
building this crucial skill set, everything else a trader achieves
including emotional mastery will be for naught.

While low and high
are quantified in terms of prices, context is necessary to
define them. A price considered in isolation is useless, but a
price considered in context offers much insight. If I tell you I
bought something today for $50, you have no idea whether I got a
good deal at a low price or got robbed at a high price. What if my
$50 bought me a new Nintendo Wii console? What if it bought me a
hamburger?

Since you
generally know the price history of Wiis and hamburgers, you
immediately have the context necessary to make the low/high
judgment. Traders must strive to understand today’s prices in a
relevant context, because only then can we make sound trading
decisions. If prices are simply normal like they are most of the
time, traders should do nothing. But when they occasionally get low
enough to buy cheap or high enough to sell dear, traders must be
ready to act.

About 7 years ago,
I was looking for a simple, elegant, and effective way to quickly
and objectively make low/high judgments about the markets I was
trading. I tried many existing trading systems, but all were
ultimately unsatisfying. They had too many rules, too many
exceptions to those rules, and were too time-consuming and
cumbersome to apply when the markets were moving. So I developed my
own system.

I called it
Relativity, because all prices are relative. The low/high
question can only be answered relative to recent history. In
the 5 years since I publicly introduced
Relativity,
many new traders have entered the markets who could really benefit
from this system. And after 5 years of actively applying Relativity
to my own trading, with much success and some failures, my own
understanding of Relativity is much deeper.

The easiest way to
internalize the concepts and power of Relativity trading is to walk
through an example. The gold price between 2002 and 2005 is an
excellent one. Since I formulated this theory back then using
this very dataset, it is certainly nostalgic for me. But far
more importantly, this past example eliminates all the warring
emotions surrounding today’s prices in today’s markets. Greed and
fear from this historic period has long since evaporated, so
everyone today can analyze it with cold logic sans emotions.

No matter where,
when, or what you trade, the mission is always the same. Buy low,
sell high. During the young gold bull rendered here, the
contrarians then trading it faced the same challenge of defining
these conditions. And clearly price alone wasn’t enough. In early
2003, $375 looked awfully high compared to the $311 gold averaged in
2002. Yet by late 2003, that same $375 started feeling normal. And
by mid-2004 it felt low. Later $425 had the same high, normal, low
evolution between early 2004 and mid-2005.

In any trending
market, bull or bear, prevailing baseline price levels gradually
change. The actual prices that feel high, normal, and low in
any market today won’t feel high, normal, and low in that same
market a year or two from now. It is the context, recent price
history, that defines where a particular price happens to rank
in the buy/sell continuum. Technical analysis, the study of price
action, seeks to define this context.

Drawing trend
channels is probably the most common way to put prices in context.
It is very easy, like connecting the dots in a child’s coloring
book. A trader manually draws a best-fit line across either all the
high prices or all the low prices on a chart. Then he draws a
second parallel line on the opposite price extreme to complete a
trend channel. This is the space between the lines where most of
the price activity occurred.

The lower line of
a trend channel is called support, because whenever a price
nears this line new buying tends to come in that drives the price
higher (supports it). The upper line is resistance, because
new selling tends to emerge near this level which keeps the price
from breaking out higher (resists it). This simple technical
analysis is very useful, as traders can buy low near support and
sell high near resistance.

While I am a fan
of technical analysis and use it a lot in my own trading, the big
problem with trend channels like these is they are subjective and
imprecise. Since these lines are hand-drawn, they always differ
from chart to chart and analyst to analyst. And deciding when a
price is low enough or high enough for action is an eye-balling
exercise of guessing. There is no standard, no way to replicate the
buy/sell continuum, and no way to quickly communicate low or high
prices without a chart.

Trend channels
have deeper mathematical limitations too. In this gold chart, the
trend channel I drew encompasses a gold swing of about $60. In
2002, a $60 gain off a $275 base represented a 22% move higher. But
in 2005, this same full-channel swing of $60 off a $425 base equated
to just a 14% move. Over time linear trend channels distort
probable percentage moves leading to poorer trading decisions. And
logarithmic charts aren’t an ideal solution, they have plenty of
problems of their
own.

As I pondered this
puzzle years ago, I was looking for a measurable, objective,
undistorted standard from which to determine whether prices were low
or high. And although it took me some time to realize it, the
answer was staring me right in the face! The venerable 200-day
moving average, rendered in black in our Zeal charts, effectively
defined the ideal metric I was looking for to measure baseline price
levels.

200dmas are simple
constructs. Today’s closing price, along with the previous 199
trading days’ closing prices, are added together and divided by
200. As the name states, a 200dma is merely the average closing
price level over the previous 200 trading days. Tomorrow, the whole
average slides forward by 1 day, adding the latest close while
dropping off the oldest one from 201 trading days ago.

This intrinsic
math means a 200dma gradually inches ahead, trailing the
price action that created it. Since calendar months typically
average about 21 trading days each, a 200dma is essentially a
10-month average. This turns out to be an ideal baseline from which
to measure prices. While a 200dma gradually evolves to reflect
changing baseline price levels, it still morphs slowly enough to not
be excessively influenced by daily volatility.

Examine the black
200dma in the gold chart above. It parallels the hand-drawn
trend channel! In the secular trends that are the most profitable
to trade, 200dmas are like big arrows pointing the way prices are
heading. This construct’s natural smoothing effect distills away
all the capricious day-to-day volatility, revealing the core essence
of the prevailing secular trend. In addition, 200dmas are totally
unbiased.

A thousand
different analysts calculating the 200dma on the same price series
will get the exact same result, this standard is rigidly objective.
This is a welcome contrast to the inherent subjectivity of drawing
trends, where a thousand analysts would get a thousand different
results. And a price’s relationship with its 200dma can be quickly
communicated without a chart. It is easier to both transmit
and digest.

200dmas are the
perfect compromise between static and excessively dynamic
baseline-price measures. While 200dmas are slow to change, they
do still gradually change over time. So they won’t fade into
obsolescence like all static measures, including trendlines,
inevitably will. Simultaneously, they are not unduly influenced by
the latest price action (most recent few weeks) that heavily colors
traders’ sentiment.

Occasionally a
fellow student of the markets will ask me, why the 200dma? Why not
a 175dma, or a 250dma? This is a good question, as odds are any
long moving average will work in a similar way as a slowly changing
baseline price level. I chose simple arithmetic 200dmas
because they are common and popular, ubiquitous on almost all
charts. If an atypical moving average was used, then Relativity
would be more cumbersome because it couldn’t be calculated without
raw data, a spreadsheet, and too much time.

The gold period
charted above shows a perfect example of how useful the 200dma
baseline is to traders. Anytime gold was near or under its 200dma,
it was a great time to buy. Its price was relatively low
compared to its 200dma. And anytime gold stretched far above its
200dma, it was a great time to sell. Its price was relatively
high compared to its 200dma. This flowing and ebbing distance
between a price and its 200dma is the core of Relativity trading.
200dmas provide the crucial context from which low/high judgments
can be made!

The deeper your
understanding of 200dmas grows, the easier it is to see why they are
so venerated by technicians. In most secular bulls like this gold
one, the 200dma forms the most important foundational support line.
In most secular bears, the 200dma is the most important overhead
resistance line. If you buy near a 200dma in a bull, and sell near
a 200dma in a bear, your trades have high odds of proving
successful.

At this point in
my ode to 200dmas, there is still too much subjectivity in defining
baseline-price context. While the 200dma itself isn’t the least bit
arbitrary, deciding when a price is low or high relative to its
200dma is. It still requires eyeballing a chart, just like
trendline analysis. Years ago as I pondered this problem, a simple
idea eventually came to me. Why not view prices as a multiple of
their own 200dma?

Instead of saying
gold at $380 in February 2003 “looks” or “feels” high, why not
empirically measure it? If gold’s closing price is divided by its
200dma that day ($324), it yields a multiple of 1.174x (read this as
“one-point-one-seven-four times”). I call this Relative
gold, or rGold. On that particular day gold happened to close at
1.174x its 200dma, or in other words 17.4% above its 200dma.
Subjectivity has vanished!

Now we have a
strict mathematically-defined baseline, the 200dma, and an equally
objective measure of the distance from that 200dma in the relative
multiple (price divided by 200dma). There is no judgment involved
here, and the resulting multiple can be easily communicated without
its underlying chart. My Relativity construct is a simple, elegant,
and effective way to quickly place today’s prices within context in
order to make well-informed low/high price judgments with excellent
odds for success.

But even with such
rigidly-defined relative multiples, the problem remains of where
these multiples should be considered low enough to buy or
high enough to sell. One more additional layer of context is
necessary, and that is the range through which a price’s relative
multiple has traded in recent years. This concept led to our famous
Zeal Relativity charts, like the gold one below from the same
2002-to-2005 period.

The result of
charting relative multiples over time is rather fascinating. It
effectively takes the black 200dma line and flattens it into a
perfectly horizontal line at 1.00, which is logical since the 200dma
is always exactly one times itself. And when the relative
multiples over time are plotted on this Relativity chart, the result
is a horizontal trading range. In trending markets, relative
highs and lows tend to be recurring.

Behold Relative
gold, the red series plotted on the left axis. The usual gold
technicals are slaved to the right axis. The distance between the
red rGold line and 1.00x is the Relativity projection of the
distance between the blue gold price and its black 200dma. And with
this projection, all percentage distances are identical and
perfectly comparable across time. Relativity totally eliminates
the visual distortion created by changing baseline price levels.

Gold’s
relationship with its 200dma, its most foundational support line
over these years, suddenly becomes crystal clear. The gold price
has traded within a well-defined percentage range around its 200dma,
which the red rGold line traces. After seeing this data, all we
need to do is define a relative trading range based on it.
Although this selection is admittedly subjective, the impact is
minimal since relative ranges are percentage constants. Thus visual
distortion doesn’t affect the chosen best-fit relative trading
range.

Five years ago
when I penned my
original essay
on Relativity, I chose an rGold trading range running from less than
0.99x to greater than 1.14x. This range should be considered an
analog continuum gradually fading from
high-probability-for-success times to go long near low multiples on
the bottom to high-probability-for-success times to go short near
high multiples on the top.

In this rGold
example, the closer gold is to 0.99x, or the lower its relative
multiple happens to be, the better the chances that a new upleg is
imminent. This provides the context warning traders that gold
prices are relatively low, an anomalous state that probably won’t
last for long within a secular bull market. In order to buy low,
traders must hold off on adding new gold positions until rGold
trades near or under 0.99x.

Conversely, the
closer gold gets to 1.14x, or the higher its relative multiple
happens to be, the greater the odds that a correction is imminent.
Note in this chart that gold never remains stretched far above its
200dma for long. This too is an anomalous state that cannot
persist. In order to sell high, traders should consider exiting
positions, or at least putting protective trailing stops on them,
when rGold approaches or exceeds 1.14x.

Remember that the
absolute price is meaningless. If gold is at $400 but its 200dma is
at $300 (1.33x multiple), it is radically more overbought than if
gold is at $800 with its 200dma at $750 (1.07x). Prices are only
relevant within context, and Relativity excels in providing this
context. While a price itself doesn’t matter, the speed with
which it got to its current levels is critically important for
traders.

Ultimately all
this ties into psychology, the sentiment that drives short-term
price moves. Prices get ahead of themselves, or overbought, because
greed suddenly flares too intensely. Once all the traders
interested in buying soon have already bought, only sellers are left
so the price soon falls. This unsustainable greed-driven spike
manifests itself as a price rapidly surging well above its 200dma,
creating the high relative multiple which warns it is time to sell.

And prices get
oversold because fear gets overdone from time to time. But once
everyone interested in selling soon has sold, only buyers are left
so the price recovers. In Relativity terms these conditions are
revealed by low relative multiples heralding the time to buy. A
price’s ongoing relationship with its 200dma provides all the
context necessary to understand whether it is low or high and
whether you should buy or sell.

While I used gold
in this explanation of Relativity trading, these principles work in
all trending markets. Bulls all unfold like this, with the
mathematics of the 200dma making a price appear to bounce up along
its 200dma over time. Bears work similarly, but their prices appear
to bounce lower underneath descending 200dmas over time. So
bull relative-multiple ranges are always mostly above 1.00x, while
bear ones are always mostly below it.

The primary caveat
to Relativity is it is only designed for markets in long-term
trends. So it breaks and fails in two key situations that
traders must remain wary of. The first is during secular reversals,
the transition between bull and bear. While there are plenty of
ways to recognize such transitions, realize that Relativity trading
won’t work across them. The second is during wild price anomalies
like last year’s stock panic, when prices suddenly blow out of
trends and break every trading system. Thankfully these are
exceedingly rare events.

At Zeal we
carefully watch the relative trading ranges of 10 key prices across
the stock-market, currency, and commodities realms. In every weekly
Zeal Speculator
trading alert and monthly
Zeal Intelligence
newsletter we publish, we outline the current multiples and their
recent ranges which are so useful in making trading decisions. In
addition, each week we update large high-resolution charts of each
relative indicator on our website for our subscribers. This
information is incredibly valuable for all traders.

In the new October
issue of Zeal Intelligence, we just refreshed our list of relative
indicators and discussed why this updated set is so important for
commodities-stock investors and speculators today. I also explained
how you can use Relativity principles to check individual stocks on
your own, to decide whether they are likely good buys or not. All
this is in addition to our usual acclaimed market analysis and
trades, and this October ZI is free for first-time
e-mail-PDF-edition subscribers!
Subscribe today
and start thriving!

The bottom line is
price action is only relevant within context. Traders simply can’t
make sound buy/sell decisions unless they can make informed low/high
judgments about current price levels. Relativity, by considering
200dmas as evolving price baselines and building an objective
measuring system around them, is a phenomenal tool for making these
decisions. It should be a key part of every trader’s toolbox.

And due to the
very nature of the interaction between any price and its 200dma,
these Relativity trading principles are universal. As long as a
market is trending, they work anytime anywhere. By simply
considering where a price happens to be relative to its 200dma
today, and the range of this relationship in recent years, you can
radically increase your odds of succeeding in buying low and selling
high.